Bubble may just be bogus

Published 4:00 am, Sunday, July 10, 2005

On Thursday I gave some reasons why the housing market might be a bubble ready to burst. As promised, here's the other side of the story.

Housing bulls say home prices are soaring not because of a speculative bubble, but for a simple economic reason: Supply has not kept up with demand.

On top of organic demand for homes due to population growth, immigration and divorce, many people now see housing as a better and more enjoyable investment than stocks, which you can't live in or can't trust, and bonds, which are yielding next to nothing.

Low interest rates and more liberal lending standards have allowed more people to buy homes, helping to raise the U.S. homeownership rate to 69 percent from 64 percent over the past decade.

Also fueling demand is the 1997 tax law that lets married couples sell a primary residence and pay no tax on up to $500,000 in profits as often as every two years. (The limit for singles is $250,000.)

Meanwhile, the supply of new homes has not kept up with demand because there is less vacant land within reasonable commute distance of job centers, and that's because governments and environmental groups have made it harder to build and developers have not overbuilt like they have in past booms.

Housing bulls expect these trends to continue, unless there is a recession or sharp increase in interest rates, which they don't anticipate. Although many expect the rate of home price appreciation to moderate, and possibly fall in some overheated markets, they don't see home prices nationwide declining and certainly not by 15 or 20 percent -- a drop that would qualify as a bubble bursting.

"I'm hard pressed to see why housing, barring some major international event, is going to decline in the foreseeable future," says Bob Curran, who rates homebuilder debt for Fitch Ratings.

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One way to look at supply and demand is to look at the number of homes sold (which represents demand) and the number of homes for sale (which represents supply).

In 1990, there were 2.9 million existing homes sold. In May, homes were selling at a rate of 6.21 million per year. That's an increase of 114 percent, says Samuel Lieber, manager of the Alpine U.S. Real Estate Equity Fund.

In May 1990, there were 2.32 million existing homes for sale. Today, there are only 2.22 million for sale, 4 percent fewer than 15 years ago.

Lieber says demand for existing homes has grown by 114 percent and supply has fallen by 4 percent.

For new homes over that period, demand has grown by 143 percent and supply has grown by 23 percent.

Another supply/demand indicator is the unsold inventory index, or the number of months it would take at the current rate of sales to sell all homes on the market.

Since 1970, this index has ranged from 3.5 months to 11.5 months, says Lieber.

An index of 5.5 to 6 months means supply and demand are in rough equilibrium.

In May, the index for existing homes nationwide was 4.3 months, which means demand moderately outpaced supply. It was 3.8 months in May 2004.

Since 1997, this index has hovered between 4 and 5, which suggests "the builders are trying not to build a lot of speculative inventory. They are trying to build more to order," Lieber says.

In California, the index for existing homes was 2.8 months in May, compared with 1.6 months in May 2004.

Price history

Housing bulls point out that home prices are "sticky" on the downside. If prices decline, owners simply pull their homes off the market. Unlike stocks, they can't be sold with a phone call, and transaction costs are very high.

"Since they started keeping track in the early 1950s, there has never been a nationwide decline" in home prices, says David Berson, Fannie Mae's chief economist,

Since 1976, there have been nine years -- in the early 1980s and early 1990s -- when home prices did not keep up with inflation, according to Fitch Ratings.

There have been regional busts, usually brought on by economic jolts like falling oil prices, which hurt Texas in the late 1980s and early 1990s, and defense cutbacks, which hurt Southern California in the mid-1990s.

When that happens, people might move from California to Arizona, but they tend not to leave the United States, which is one reason prices nationwide don't decline, says Berson.

Booms and busts

Even regional booms usually are not followed by busts, according to a recent report from the Federal Deposit Insurance Corp.

It defined a boom as a 30 percent or greater increase in inflation- adjusted (or real) home prices during any three-year period. It defined a bust as an average decline in nominal (not inflation-adjusted) home prices of at least 15 percent over five years.

Between 1978 and 1998, it found 54 instances of housing price booms and only 21 instances of home price busts.

That means only 17 percent of booms ended in busts. Most booms, it says, were followed by periods of price stagnation.

However, the paper goes on to say that "history might be an imperfect guide to the present situation." It said changes in credit markets are pushing homeowners -- and housing markets -- "into uncharted territory."

It cited a nearly tenfold increase in subprime mortgage loan originations between 1993 and 2004. "While the growth in subprime lending has made home ownership an option for millions of households ... it has also been associated with higher levels of delinquency and foreclosure," the FDIC said.

It warns that in 2003, loans exceeding 80 percent of the home purchase price accounted for 30 percent of all purchase mortgages nationwide and that more borrowers are taking on piggyback loans, which usually combine a first mortgage for 80 percent of the home's value with a second mortgage for most of the rest.

"The effect of this structure is to raise the total loan amount to a level very near the value of the home, which may make borrowers more likely to default in the event of a housing market downturn," it says.

Foreclosure activity

Despite the big increase in riskier loans, mortgage delinquencies and foreclosures are low.

At the end of the first quarter, only 4.31 percent of home mortgages nationwide were delinquent and 1.08 percent were in the foreclosure process, according to the Mortgage Bankers Association. Those numbers were down slightly from the previous quarter and the same quarter last year.

In the second quarter of 2002, 4.77 percent of homeowners were delinquent in their mortgage payments and 1.23 percent were in foreclosure.

Foreclosure activity in California is below the national average.

This is heartening, but not surprising. As long as housing prices are going up, people who get into financial trouble can usually sell their homes at a profit.

Housing bears are also concerned that so many homeowners -- roughly one third -- are choosing adjustable-rate mortgages at a time when fixed-rate mortgages are so cheap.

If people are taking out ARMs to buy a house they couldn't afford with fixed-rate mortgages, that's risky. But Curran thinks many people are simply making a wise financial decision by choosing hybrid ARMs. These loans have a rate that is fixed for three to 10 years, then becomes adjustable. As many as 70 percent of ARMs are hybrids, he says.

Because most people stay in their home less than 10 years, a hybrid gives the advantages of a fixed rate, at a lower cost, Curran says.

Homeowners with traditional ARMs, which are tied to short-term rates, could be in for a surprise the next time their payments adjust because short- term rates have risen substantially since June 2004, when the Fed started raising the federal funds rate.

"That could certainly help deflate the bubble," says Brad Sorensen, an analyst with Schwab Center for Investment Research. "But a 5 percent retrenchment or a flat market would not be a bubble bursting."

The National Association of Realtors' affordability index was 122.8 in May, down from 132.6 the previous May but far from its all-time low of 63.9 in September 1981. An index of 100 means a family with the median income has exactly enough income to qualify for a mortgage on a median-priced home, assuming a 20 percent down payment.

Affordability in California is much worse. In May, only 16 percent of households could afford a median-price home, according to the California Association of Realtors. That's down from 17 percent in April and 19 percent in May 2004.

The all-time low was 14 percent in May through June 1989. (The association started tracking the index in 1988.) Housing prices, however, continued rising for more than a year.

Last year, the share of homes purchased in California by first-time buyers hit 26 percent, a record low. The average is 40 percent and, in 1995, first-timers made up half the market.

"We have to be concerned that affordability is approaching an all-time low," says Robert Kleinhenz, deputy chief economist with the California Association of Realtors. But he points out that "usually price continues to rise beyond the trough in affordability."

Falling affordability "has to slow the pace of price appreciation, unless you get people immigrating from other parts of the country or abroad," says Lieber, whose fund has a large stake in home-building stocks.

"I think we have a market that is going to flatten out," he says.

Lieber says the fundamental reason that housing "is not in a bubble in most markets is that homeownership is still a more attractive option than renting for those who can afford it. People want a piece of America they can call their own."

Does Lieber think California is a bubble? "No. It's expensive, but it has been for three decades. San Francisco could be a bubble, but people thought it was two years ago and prices still went up."